What Might Have Been, and the Fall of Lehman

As we observe the five-year anniversary of the financial crisis — Lehman Brothers filed for bankruptcy five years ago this coming weekend — the most intriguing hypothetical question about those fateful days is what would have happened had the government bailed out Lehman.

It would have changed the course of history, certainly, but maybe not for the better.

The collapse of Lehman has long been considered the domino that led to the tumbling of so many others: Merrill Lynch's hasty sale to Bank of America; the bailout of the American International Group; the breaking of the buck in the money market; the near collapse of Goldman Sachs and Morgan Stanley that led them to become banking holding companies; and the decision by the government to pursue the $700 billion Troubled Asset Relief Program to bail out the entire banking industry.

The decision not to rescue Lehman has been called a mistake and worse. Christine Lagarde, the French finance minister at the time, called it "horrendous."

No one suggested Lehman deserved to be saved. But the argument has been made that the crisis might have been less severe if it had been saved, because Lehman's failure created remarkable uncertainty in the market as investors became confused about the role of the government and whether it was picking winners and losers. The government had bailed out Bear Stearns and then nationalized Fannie Mae and Freddie Mac but left Lehman for dead only to turn around and save A.I.G.

Henry M. Paulson Jr., the Treasury secretary at the time, has suggested that the government didn't have a choice because it lacked the proper tools to take over Lehman without a willing buyer. The British government pulled the plug on Barclays's 11th-hour bid, a brilliant decision in retrospect.

Mr. Paulson may be right: he didn't have the tools. But that didn't stop the government from finding clever ways to bail out A.I.G. and then pursuing strong-arm tactics — like pressing Bank of America to complete its deal for Merrill without disclosing the severity of Merrill's problems to shareholders — that would have been considered unconscionable had the country not been in the midst of a crisis.

Of course, the government was hardly predisposed to participating in a bailout of Lehman, despite assertions that it was prepared to help. The contemporaneous evidence is overwhelming: "looks like Paulson will go to NYC to sort through this Lehman mess … can't imagine a scenario where we put in gov't money … we shall see," Jim Wilkinson, Mr. Paulson's chief of staff, wrote to a recruiter on Sept. 12.

Two days later, he sent another e-mail to Jes Staley, the head of global asset management at JPMorgan Chase: "No way govt money is coming in … I'm writing the usg coms plan for orderly unwind … also just did a call with the WH and usg is united behind no money. No way in hell Paulson could blink now."

That's where the hypothetical guessing game begins. But there are some educated assumptions that can be made. The blowback against a bailout of Lehman would have been fierce. It is often forgotten, but the prevailing wisdom the day after Lehman fell was that its collapse was a good thing. The New York Times wrote in an editorial: "It is oddly reassuring that the Treasury Department and Federal Reserve let Lehman Brothers fail." (The Wall Street Journal came out on the same side.)

It is also worth noting that most of Wall Street was convinced that the failure of Lehman Brothers would not pose a systemic risk. "I think the market can take the lehman unwind, but there needs to be a bid for Merrill early in the week," Mr. Staley had e-mailed to Mr. Wilkinson over the weekend.

In truth, in the fairy-tale version of bailing out Lehman, the next domino, A.I.G., would have fallen even harder. If the politics of bailing out Lehman were bad, the politics of bailing out A.I.G. would have been worse. And the systemic risk that a failure of A.I.G. posed was orders of magnitude greater than Lehman's collapse.

Had the Fed stepped in to save A.I.G. at that point anyway, despite the politics, it then becomes increasingly unlikely that the Treasury Department would have been able to muster enough Congressional support to pass TARP. At the very least, the size and scope of it would have been curbed. And remember, even with the stock market and economy in free fall, Congress originally rejected TARP before it reversed itself days later after the markets appeared to be gripped in a death spiral.

As Rahm Emanuel said in 2008: "You never want a serious crisis to go to waste. And what I mean by that, it's an opportunity to do things you think you could not do before."

The failure of Lehman may have allowed the government to do more to prop up the economy than it otherwise could. Niall Ferguson, the historian, put it this way a year after the crisis in an opinion article in The Financial Times: "Like the executed British admiral in Voltaire's famous phrase, Lehman had to die pour encourager les autres — to convince the other banks that they needed injections of public capital, and to convince the legislature to approve them."

Ed Lazear, chief economic adviser to President George W. Bush, told a group of students at the University of Chicago Booth School of Business, however, that thinking about the crisis as a series of dominoes may be the wrong analogy.

"Under the domino theory of contagion, one domino falls and knocks over the other dominoes, and they all topple, and you've got a mess on your hands," he said. "That's pretty much what we were thinking in saving Bear Stearns. That looked like the way to go. Unfortunately, the model was not dominoes; it was popcorn.

"When you make popcorn, you heat it up in a pan and, as the kernels get hot, they pop. Taking the first kernel to pop out of the pan doesn't do anything. The other kernels are still getting hot, the heat is on, and they're going to pop no matter what," he said.

Of course, if this column had more space, there's always the question of what would have happened if the government had not bailed out Bear Stearns. …